Question

How does operating a budget surplus reduce purchasing power in an economy?

Answer 1

Government budget is composed of revenue and spending. A budget is said to be in surplus when the government is able to earn more than what it can spend. With increased government surplus there is an increase in public savings. This shift the supply curve of loanable funds in the loanable funds market.
With the increase of supply of funds the interest rate on loanable funds falls. This increases the investment spending and consumption spending. Both of these are a part of aggregate expenditure and therefore aggregate expenditure is increased. The aggregate demand curve shifts to the right in the AD AS diagram. Such a shift will increase the price level in the short run in the economy and will reduce the purchasing power of the currency. This is true because the increase in the price level brings inflation and inflation erodes the purchasing power of money.